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FINANCIAL INSTITUTIONS AND MARKETS
“BIG BANG” ON KOREA’S CAPITAL MARKETS: REFORM LEGISLATION AND
ITS IMPACT
By Cho Sung-hoon
Introduction
Along with commercial banks, capital markets are an
integral part of the financial systems in most capitalist economies, and their relative importance is constantly increasing. Countries around the world are
making enormous efforts to enhance the competitiveness of their capital markets and investment services
industries. Korea is no exception to this trend.
The macroeconomic environment of Korea is changing. First, the main driving force of Korean economic
growth is the movement into high-technology-based
innovative industries. For example, in 2003 the Korean government selected 10 “new growth-driving
industries” including display, next-generation semiconductors, and bio-medicine. Those industries have the
characteristics of high risks and high returns, and they
require financing with long-term risk capital. Capital
markets should be the primary source of risk capital
financing because commercial banks, which are directly responsible for the stability of the whole financial system, cannot bear the amount of risk such investments require. Therefore capital market development is an essential task for the sustainable growth of
the Korean economy. The rapid aging of the Korean
population is another reason why capital markets
should be developed. As life spans become longer,
efficient intertemporal smoothing of consumption and
income is becoming more important for a comfortable life after retirement for every individual. Individuals and households demand capital market products that can meet these needs.
Currently, the Korean government is processing legislation for a new, revolutionary law called the Capital
Market and Investment Services Act (CMISA), which
is also called the Consolidation Act. Six existing laws
governing capital markets and the investment services
industry, including the Securities Exchange Act, the
Futures Trading Act, and the Collective Investment
Act, are consolidated into the CMISA and will be replaced by it. If the CMISA is approved by the Korean
National Assembly in the spring of 2007, according
to the government’s expected schedule, it will take
effect in the winter of 2008, after a one-and-a-halfyear preparation period.
The CMISA includes some fundamental changes to
the legal environment surrounding the capital markets and investment services industry of Korea, and
it is expected to bring about a great change and transformation. We can even call the CMISA legislation
Korea’s version of the big bang! The impact of this
big bang is expected to be most outstanding in the
investment services industry. In this article, we try to
assess the impact of the CMISA and identify some
important challenges imposed on the Korean investment services industry to enhance its competitiveness in the upcoming totally new legal environment.
The article proceeds as follows: In the next section,
the current situation in the Korean investment services industry and its legal environment are briefly
described. In section 3, the core provisions of the
CMISA are discussed. Challenges imposed by CMISA
to Korean investment services industry are discussed
in section 4, and section 5 concludes.
Korea’s Investment Services Industry
Today
After the Asian financial crisis of 1997, securities firms
(broker-dealers and investment banks) in Korea be-
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19
gan to face much fiercer competition.1 Firms were
allowed to freely set the level of their brokerage commissions, and price competition intensified. The explosive growth of online (cyber) trading also made
the price competition even tougher. As a result, the
average stock brokerage commission rate dropped
dramatically from more than 50 basis points in 1999
to less than 17 basis points in 2006. Because Korean
securities firms heavily rely on the brokerage business—their brokerage business accounts for more
than 60 percent of total net revenue of Korean securities firms on average—this rapid drop in commission rates directly brought about a deterioration of
profitability.
Securities firms are key players in capital markets,
and the competitiveness of securities firms is a very
important factor for capital market development. Unfortunately, it is hard to say that the competitiveness
of Korean securities firms is strong. It is a pressing
task for Korean securities firms to find alternative
sources of revenue to compensate for reduced profitability in their brokerage businesses. This is especially important because the weakest area of Korean
securities firms is investment banking, which is the
area most closely related to Korea’s macroeconomic
needs.
Various explanations have been put forward for the
low competitiveness of Korean securities firms, and
one can hardly deny that Korea’s legal and regulatory
environment is one of the most significant reasons.
First, investment products and services are very narrowly defined because of related laws. For their corporate customers and investor customers, securities
firms can deal only with products that are explicitly
listed in the current Securities Exchange Act. For
derivatives, underlying assets upon which derivative
products can be written are listed in the Futures Trading Act. As a natural consequence of this “positive
listing system” of financial products, securities firms
have little incentive to develop the capability of
designing innovative new financial products, which
is a key success factor for the investment banking
business.
Second, businesses that Korean securities firms can
carry on are also very strictly limited by various laws.
Similar to the United States and Japan, a solid firewall
exists between commercial banking and investment
services in Korea.2 In fact, other firewalls—although
these are more porous—exist for various investment
services businesses. For instance, securities firms can
carry on neither an exchange-traded derivatives business nor an asset management (fund) business in principle. Similarly, futures trading firms, which are governed by the Futures Trading Act, cannot also have a
securities (stocks, bonds, or asset-backed securities)
business. With these heavy regulations, it is difficult
for Korean securities firms to pursue diverse business strategies, and this has made business portfolios
of Korean securities firms quite similar regardless of
the differences in firm characteristics, such as size.
The CMISA legislation is driven by the perception that
there is little hope of further enhancing Korean securities firms’ competitiveness under the current legal
and regulatory environment. In this sense, the CMISA
legislation is a landmark; it is the total overhaul, not
just a partial modification, of the legal environment
surrounding Korean securities firms, and it can be
viewed as an epochal event. In the following section,
some of the important provisions of the CMISA are
described.
Main Provisions of the CMISA
The CMISA is a completely new law consolidating
six existing laws governing capital markets and the
investment services industry of Korea.3 The first im-
1. What is called the investment services industry includes various businesses—broker-dealers, investment banks, asset management,
and investment advisory firms, for example. In this article, we focus on securities firms, mainly broker-dealers and investment
banking.
2. In the United States, this firewall has been lessened by the Gramm-Leach-Bliley Act of 1999, but the provision of commercial
banking and investment services in a single entity is still prohibited.
3. The six laws that are consolidated into the CMISA are the Securities Exchange Act, the Futures Trading Act, the Collective
Investment Act, the Trust Service Act, the Korea Exchange (KRX) Act, and the Merchant Banking Act.
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portant provision of the CMISA is the change in the
definition of investment products. The CMISA abandons the positive listing system, and the scope of investment products will be dramatically broadened.
Under this new regime, any financial product that
meets basic economic properties specified in the
CMISA is recognized as an “investment product” and
can be served by securities firms. Specifically, the
CMISA defines an investment product as a financial
product that involves the risk of the loss of invested
principal. The CMISA also defines derivatives as investment products that involve the risk of liabilities
additional to principal loss, and the law defines securities as investment products with no such risk. In
addition, the CMISA broadens the scope of underlying assets upon which derivatives can be written into
“any quantifiable risk”; for example, derivatives upon
energy, weather, or emission rights will be able to be
written. Under this new regime, the frontiers of product
innovation for securities firms will be vastly widened.
The second core aspect of the CMISA is that the
firewalls among investment service businesses are to
be abolished. The CMISA allows a single firm to carry
out various capital market and investment service
businesses, and it calls these firms “financial investment firms.” For example, a financial investment firm
can do brokerage, investment banking, derivatives,
and asset management work in-house only if it gets
licenses for each business. With these two huge
changes in the regulatory framework, it is expected
that Korean securities firms will evolve into true investment banks that can be compared in their business scope and economic functions with global players such as Goldman Sachs and Morgan Stanley. This
is a major objective expected to be achieved by the
CMISA legislation. Korea’s new financial investment
firms can practically be viewed as investment banks.
Another important feature of the CMISA is the restructuring of the regulatory scheme. Currently,
Korea’s financial regulation is structured in line with
institutions. As an illustration, the Financial Supervisory Commission (FSC), a single, integrated government watchdog for financial markets and industry in
Korea, and the Financial Supervisory Service (FSS),
the implementation arm of the FSC, are organized in
line with financial institutions such as banks, securities firms, insurance companies, and so on. Therefore when an investment service is provided by two
different institutions, regulation of the service imposed
on each institution may be different, and there can be
an opportunity for regulatory arbitrage. Under the
CMISA, Korea’s financial regulatory scheme will be
restructured to functional regulation, under which a
single regulation is imposed on a single investment
service regardless of the institutions that provide it.
Investor protection is expected to be stronger under
the CMISA. New devices for investor protection such
as the know-your-customer rule and the suitability
principle are introduced, and the disclosure rules get
additional refinement in the CMISA. By differentiating (presumably) more sophisticated institutional investors from ordinary retail investors, the regulatory
burden of financial institutions for investor protection is expected to become more rationally balanced.
Challenges to Korean Securities Firms
The CMISA is expected to bring about huge changes
and transform the capital markets and investment services industry in Korea. Securities firms’ business
models will be much more diverse, and this may provide stronger incentives for mergers and acquisitions
in the investment services industry. Therefore the
structure of these industries under the CMISA will be
very different from the current structure. Some securities companies will evolve into true investment
banks (that is, financial investment firms) in the sense
that they will function as a total financial solution provider for corporate and investor customers. Those
financial investment firms will be able to provide much
more custom-tailored products or solutions to meet
diverse needs of individual customers. The risk-bearing capacity of the whole Korean financial sector, including commercial banks and insurance companies,
will be enlarged as these investment banks play more
active roles as risk bearers. But it is important to remember that the CMISA meets only the minimum
conditions necessary for all these changes and developments. Korean securities firms need to deal with
some important challenges and tasks in order for the
CMISA to bring about a real big bang.
First, the economic functions of Korean financial investment firms should be upgraded. The current economic function of Korean securities firms is simple
brokering, even in the investment banking business.
Investment products are predetermined by law, and
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companies issue those predetermined investment products (securities) to raise capital. Investors simply put
their money in those products. In this process, all
that investment bankers in Korean securities firms do
is link issuing companies and investors. Korean
financial investment firms should be able to provide a
more sophisticated function, a sort of asset transformation. Investment bankers should be able to devise
and provide products for raising capital that meet the
issuing companies’ needs. Financial investment firms
buy those products with their own money and provide issuing companies with capital. Therefore,
financial investment firms bear a great deal of market
risk. They make products bought from issuing companies into other investment products that can meet
diverse investors’ preferences through various financial engineering techniques, and they sell those products to investors. In this process, financial investment firms transform the risk-return profile of investment products; that is the key feature of the asset
transformation of financial investment firms. With this
asset transformation, financial investment firms can
hedge their market risk. It is often mentioned that the
key factors in Goldman Sachs’s incomparable competitiveness as an investment bank are its cutting-edge
techniques for this asset transformation.
The asset transformation function of financial investment firms naturally requires quite an aggressive attitude toward risk, but Korean securities firms appear
to be excessively risk averse. According to the FSS,
the average level of the capital adequacy (net capital
requirement) ratio, the prudential regulation measure
for securities firms in Korea, is about 600 percent
and well above the regulatory hurdle of 150 percent.
Korea’s three biggest firms, which are widely believed
to be closest to evolving into financial investment
firms, are even more risk averse; their average capital
adequacy ratio is above the 700 percent level. In comparison, the average level of the capital adequacy ratio of the two biggest Japanese securities firms is
below 300 percent. That is, Korean securities firms
take much less risk than Japanese firms and (most
likely) global investment banks like Goldman Sachs
and Morgan Stanley. This shows that Korean securities firms have adequate capacity for additional risk
taking at the current level of equity capital. It also
implies that enhancing the efficiency of equity capital
utilization is a more pressing task than simply increasing the size of equity capital of Korean securities firms.
The asset transformation function of financial investment firms will affect their revenue composition, and
principal investment increasingly will be an important
source of revenue. Although principal investment still
accounts for only a small portion of the revenue of
large securities firms in Korea, it is already a major
source of revenue of major global investment banks.
For example, trading and principal investment accounted for 66 percent of total net revenue for
Goldman Sachs and 31 percent for Morgan Stanley
in 2005.4 But there is a dark side in principal investment. Increased principal investment leads to increased exposure to market risk and to increased volatility in cash flow, which may have a negative effect
on the market valuation of financial investment firms.
Another important and possibly more stable source
of financial investment firms’ revenue is expected to
be wealth management or private banking services.
The market for wealth management is growing rapidly around the world. The average annual growth
rate in the number of high-net-worth individuals—
those who own more than $1 million in financial assets—has been 7.6 percent over the past 10 years.
Korea witnessed the highest growth, 21.3 percent, in
2005.5 Wealth management can generate stable and
recurring fee revenues, and it may have a positive
effect on market valuation. Under the CMISA, financial investment firms can serve customers with a much
greater variety of investment menus, and the potential of the wealth management business looks large.
The investment services industry is known to be one
of the industries that is most dependent on human
capital, and the quality of employees is one of the
most important success factors of financial investment firms. Labor productivity of Korean securities
firms is still lower than that of global investment banks.
4. These data are drawn from annual reports and the U.S. Securities and Exchange Commission Form 10-K filings of each firm.
5. 2006 World Wealth Report (Capgemini and Merrill Lynch, 2006).
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The average net revenue per employee of the three
biggest Korean securities firms is about $300,000,
half that of three global investment banks (Goldman
Sachs, Morgan Stanley, and Merrill Lynch) in 2005.
Compensation is a key to recruiting and retaining a
qualified labor force, and the compensation level of
Korean securities firms is also lower than the levels
of the global investment banks. In 2005, average compensation and benefits per employee of the three biggest Korean securities firms totaled about $100,000,
which was about one-third of the $272,000 average
for the three global investment banks cited earlier. In
Korean securities firms, employee compensation is a
relatively small part of operating expenses compared
with global investment banks. Compensation and benefits account for only 18 percent of total operating
expenses of the three biggest Korean securities firms
while they account for more than 62 percent in the
three global investment banks. This implies that Korean securities firms are rather passive in their investment in human capital development. In short, there is
a vicious circle of low productivity–low compensation in Korean securities firms, and this must be
changed to a virtuous circle of high productivity–high
compensation.
First, it is necessary to raise the level of compensation in order to provide sufficient incentives for qualified and productive manpower. Second, the compensation scheme should be improved in order to be more
closely linked to performance and productivity. It is
necessary to devise performance measures that can
show the true productivity of employees as exactly
as possible. And there is an important caveat to be
considered in designing performance measures: the
possibility of conflicts of interest. One well-known
example of this is the performance measure for retail
salespersons of the broker-dealers. Many broker-dealers and securities firms in Korea use as a performance
measure the trading value generated in customers’
accounts for each salesperson because the brokerage
commission revenue for broker-dealers is set as a
percentage of the trading value. This naturally gives
salespersons an incentive to increase the trading value
and frequency of trades—in other words, churning.
The interests of customers, firms, and firms’ employees conflict with each other in many cases. Securities firms should put a clear priority on their customers’ interests, and this should be reflected in their
performance measures. Employee turnover is very
high in the Korean investment services industry, and
therefore there is little incentive for individual securities firms to develop their human capital. This makes
industry-wide efforts and cooperation toward training well-equipped and productive manpower more
important.
The CMISA is now in the process of being finalized
as legislation in the National Assembly of Korea. Even
though most people agree with the necessity for the
CMISA, individual firms in the investment services
industry are inevitably facing uncertainty about the
legal environment. It is the government’s top priority,
which can be accomplished through the prompt passage of the CMISA, to minimize the legal uncertainty
faced by the industry.
Conclusion
Every government in every part of the world is making enormous efforts to develop capital markets because well-functioning capital markets are without
question an indispensable financial infrastructure for
economic prosperity. Reform of the legal and regulatory framework is an important part of those efforts,
and there are many such examples: the Financial Services Act (1986) and Financial Services and Markets
Act (2000) in the United Kingdom; Financial Services
Reform Act (2001) in Australia; Financial Instruments
and Exchange Law (2006) in Japan; and the GrammLeach-Bliley Act (1999) in the United States. The
CMISA in Korea is also one of those reform efforts.
The CMISA legislation is based on the perception that
it is hardly possible to enhance the competitiveness
of Korea’s capital markets and investment services
industry under the current legal and regulatory regime. Therefore the CMISA is only a fulfillment of a
necessary condition and the first step in the long journey toward a capital markets big bang in Korea. For
the big bang to take place, active responses and aggressive efforts for change on the part of the capital
market participants, especially firms in the investment
services industry including securities firms, are essential.
Dr. Cho is a Research Fellow at the Korea Securities
Research Institute.
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